Spring Forward


“The March Hare will be much the most interesting.” – Alice, in Lewis Carroll’s Alice in Wonderland

The latest week certainly left the impression of a movie that one has seen several times before. From across the Atlantic came yet another warning that all is not well in the land of the euro. It wasn’t fresh news of their unrelievingly weak economy, which, going by general stock market punditry, seems to be little more than an opportunity for the bargains of a lifetime. There was such news, but the market’s only concern was the chance of systemic crisis in the wake of an uncertain Italian election.

The fear of systemic crisis and the relative flow of central bank liquidity is really all that matters to the market anymore. That’s not to say that ordinary good news doesn’t matter, it does. Friday’s release of an estimate-beating ISM manufacturing reading sent stocks soaring and put the foot on the floor for beta. But it was nothing compared to the reassurances earlier in the week from Fed chairman Ben Bernanke that nothing would sway him from buying bonds as far as the Fed can see.

Bernanke’s Congressional appearance quickly wiped out the worst one-day loss in five months and put the markets firmly back on track to take out their all-time highs. It is their destiny, as one might guess from the Wall Street Journal’s Thursday headline advising that “Stocks Power Up to Ramming Speed” (alas, the online edition leaves out the key adjective).

I believe that they will get there, too, unless Chairman Bernanke or European Central Bank (ECB) president Mario Draghi lose their heads this month. Draghi pronounces on the 7th, Bernanke the 20th, and the voices proclaiming the improvement of the global economy will suddenly go silent and fervently hope that neither of the two buys into it, but instead keeps the spigots open. Going by the data, of which more below, I don’t see any reason for them to change course in the near term.

The Journal also led its weekend edition with a headline about the budget deadlock, and it is of course the main story for most of the media. It doesn’t really matter to the markets, though. If House Speaker Boehner does indeed follow through on the latest reporting that House Republicans aren’t interested in shutting down the government March 27th, there is almost nothing to stop the markets from another 10%-12% first quarter, just like last year. Only a surprise political crisis will matter.

The rate of economic recovery is in fact slowing down. Nominal GDP is likely to drop below 4% this year. It is reminiscent of 2007, when the danger signs were multiplying but the market roared on ahead. I expect that we will duplicate its pattern this year, with a spring top, summer correction (reality check), and then another fall top, probably inspired by another European escape (Chancellor Merkel wins re-election, perhaps).

There are pockets of doubtful credit around, but we haven’t yet reached 2007 levels (some might argue that the central banks are doing it for us). We will live at risk of a European reversal as along as its austerity program continues, for while it seems clear enough that there isn’t much sentiment for leaving the euro, there is even less for the German-led austerity program and its exchange-rate imbalances.

The reality that the US economy was going sideways before the last recession was evident by the fourth quarter of 2006. The markets shrugged and shouted “global growth!” until even some of its adherents began to tire of the phrase. The idea of “decoupling” was all the rage, and it proved to be bogus. Six years later, Europe has yet to confront a real restructuring, doing it in agonizingly slow pieces. China hasn’t confronted its own (see Morgan Stanley’s Ruchir Sharma’s provocative piece on China’s debt), yet somehow the US will escape all of this, even with global trade data signaling the contrary.

So long as the economy doesn’t collapse – and I don’t see any reason for one to be imminent without exogenous factors – the markets will go higher, the odd hiccup notwithstanding. Normal economic rhythm, even in an economy as anemic as ours, will always produce some upticks and give bulls the chance to roar that all pessimism is ill-founded. However, a lesson from 1987, 1999 and 2007 that I would pass on to you is this: The more defiant the insistence in the market media (especially on television) that the economy really is fine, the more worried you should be.

The Economic Beat

The discussion of how much the sequester matters has been a confusing one, although one consistency has been that no one has come forth to claim that it is going to benefit this year’s economy. Other than that, the arguments have lined up on political and ideological lines that were already in place. Those who benefit from a rising stock market – mutual fund managers, brokerages, the business media – tend to minimize the impact except when using it as a political cudgel on the heads of whomever they wish to blame. Those who are overweight bonds or gold (or both), or whose stock in trade is global collapse, or who wish to blame a different set of perpetrators, talk of it in lurid terms.

The answer, as is often the case, may lie in the middle and be partially obscured. The immediate financial impact from February to March should be visible, but not cataclysmic. The impact on the elusive quantity known as confidence is often apparent only well after the fact. The latest Conference Board measure of consumer confidence rose sharply this month (the level is still below average), in what may have been a simple case of being depressed after opening January’s paycheck and seeing the payroll tax bite, then opening your January investment statement in February and seeing a nice bump up in your account, perhaps finally back to pre-crash levels.

A look below the hood at the latest fourth-quarter GDP numbers suggest that the sequester’s importance may not really be visible until the first quarter’s GDP is released in April. The revision from (-0.1%) to +0.1% was a disappointment to the market, but there was some consolation in an upward revision to the third quarter rate (+3.1%, annualized) and a cherry-picked, oft-repeated observation that real final sales were revised upward from 1.1% (annualized) to 1.7%. Momentum!

Not only that, but inventories were revised downward, and that’s going to mean rebuilding in the first quarter. So more positive momentum, no?

Unfortunately, it’s circular logic. Real final sales is GDP less change in private inventories, so if inventories were revised down, then by definition real final sales go up. It’s just an accounting identity. A somewhat better read is gross domestic purchases, which fell by 0.1% in the quarter. That number was pulled down by the decrease in imports, in which the December port strike in California played a major role. It’s still not a great number, but we should get some indication of the rebound in next week’s trade report.

If imports did rebound, that is going to provide an additional drag on current-quarter GDP, since imports are a subtraction in the calculation. A second drag that is less visible is defense spending. A spike in third-quarter federal defense spending – possibly politically motivated – added about 0.5% to the quarter’s annual GDP rate. The spending subsided in the fourth quarter to its second-quarter pace, in turn pulling down the Q4 GDP rate. I feel reasonably safe in going out on the proverbial limb and predicting that the sequester will not translate into more spikes upward in federal defense expenditures.

The conclusion, then, is that the fourth quarter wasn’t quite as weak as advertised, and the third quarter not as strong. If you interpolate the two, you come up with a 1.5% rate heading into 2013, which has to navigate the payroll tax and the sequester.

Can housing make up for it? If the current rate of improvement persists in new home sales, 2013 will see an increase of about 100,000 units over 2012. The percentage increase is a giddy 27%, but the dollar impact is probably going to be between $25 and $30 billion (the latest average price was about $286K). If we stick a nice 2.0x multiplier on that, then the contribution to GDP is about $60 billion, which is less than the sequester. The payroll tax takes an additional $120 billion in disposable income.

It all seems to make the Congressional Budget Office estimate of 1.4% for 2013 GDP look better and better.

An additional limitation is, oddly enough, the stock market. Although Chairman Bernanke and others trumpet the wealth effect of the stock market, the inability of regulators to do anything about the link to energy speculation means that each equity rally gives birth to its own downfall. Equities may be purchased on 50% margin, oil futures on less than 10%. If you want more bang for your buck, you trade oil futures. Equities up, oil up more. That leads first to lower real disposable income, then into a higher deflator for GDP (taking the number down), and so on. If you’re wondering why the rebirth of US oil production isn’t helping, it’s because the world price of oil is $20 higher than in the U.S. The Keystone pipeline isn’t being built for US consumers, but to sell North American production abroad at higher prices.

I wrote in Seeking Alpha of the phenomenon of seasonal data bumps being extrapolated into permanent changes by the media and Wall Street. This results in overbought markets in the first quarter, followed by bloody payback in the second. This week’s example is weekly jobless claims, which have been bouncing around a great deal in recent weeks.

The latest weekly tally was 344,000 seasonally adjusted. I have often made the point this year that seasonal adjustment factors have been moving this number around quite a bit. Another culprit is the state of California, which has been reporting huge swings for reasons unknown to me. It may mean that the current week is too low, or that the previous week was too high, one cannot be sure yet. Two things I can be sure of, though, is that one, the improvement in claims on a year-on-year basis has decelerated dramatically. Two, I heard the radio announce yesterday that weekly claims have been falling “significantly,” which to me is an unsubstantiated claim. We are setting up for the usual letdown in the second quarter.

Elsewhere, durable goods rebounded in January: +1.9%, excluding transportation. The business investment category did show an impressive rebound of +6.3%, much anticipated after the cliff had been avoided. The overall number fell by (-5.2%), pulled down by a steep drop in transportation orders (both civilian and defense aircraft orders were down sharply, but it’s a lumpy category). December new orders and shipments were revised down.

The Chicago PMI rose to 56.8, its highest level since last March. Next year I’ll probably be reporting the same thing: The year-ago number for Chicago was 64.0. The national ISM number turned the market around on a dime Friday with an increase to 54.2 versus an expected 52.8. It didn’t hurt the rally that it was the first day of the month. It was a clean-looking number, though, one of the first in a long time to be higher than its year-ago equivalent. The growing-versus-contracting score was a healthy 15-3. It was also very much at odds with the New York, Dallas, Philadelphia and Kansas City reports, which were all light with the last two being negative. Only the Richmond Fed reported a positive surprise in its regional report. It’s an interesting contradiction.

Construction spending, which unlike survey data goes directly into GDP calculus, fell 2.1% in January. Mortgage purchase applications have been declining for several weeks, belying the increase in pending home sales (+4.5%) and new home sales, which benefited from a bump in the Western region. The Journal ran an article pointing out how much new home sales, which beat expectations at a 437,000 annualized rate, have depended on the homebuilders arranging FHA financing. While I don’t expect this to be at risk, since banks are still not anxious to lend money and the Obama administration seems most unlikely to shut down FHA lending, it may represent a speed limit on how fast home sales can grow this year.

The Chicago Fed national activity index fell sharply by (-0.32) in January. However, strong upward revisions for November and December, along with a downwardly revised October falling out of the mix, and suddenly the moving three-month datum is back in the black. Not only that, but after not having been there for quite some time, the revisions now push it up above for three months in a row. The November increase was Sandy-related; the January decrease may be cliff-related. February will need to be positive to make up for November falling out of the 3-month average next month, but the sequester will make it difficult to stay positive, even with the favorable seasonal data.

Retail sales may have been alright in February, as the weekly reports were conflicting but auto sales met expectations. February is the lightest month of the year on the retail calendar, so it doesn’t do to make too much of anything but extreme reports. Seasonal adjustments are very large this time of year for everything, including the jobs report coming out next Friday.

Tuesday’s non-manufacturing ISM makes up the other major US report next week. There are also factory orders, ADP payrolls and the Beige Book on Wednesday, and the very small same-store sales sample on Thursday. The import data on Thursday will be worth looking at to see if the December port strike washes out of the December-January combined total.

But the week is back-weighted, with the ECB monetary policy announcement Thursday and the jobs report on Friday. The latest European economic data has been weak, including the latest batch of manufacturing PMI surveys, so the ECB has some cover to cut rates if it wants to. If it does, and the jobs report is okay, equities will explode to their all-time highs, with the Dow Jones sure to get there and possibly the S&P 500 as well.

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